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CT7 Question 3 Part 4 Quiz

J

jfl123

Member
Hi,

Please could someone help me with question 3 of the Part 4 Quiz.

I might be being a bit silly, but please could you explain why the answer is A (I and II only).

Expansionary fiscal policy will result in an increase in aggregate demand and an increase in the equilibrium level of national income. This increase in the level of national income will increase the transaction demand for money, putting upward pressure on interest rates (this could be illustrated by a shift in the IS curve to the right).

Thus short term nominal interest rates will rise.

Real interest rate = nominal interest rate - inflation

Thus, if the inflation rate was constant the real interest rate would rise. However, does the increase in aggregate demand which results from expansionary fiscal policy not also cause a rise in the general price level i.e. inflation ??

Furthermore, I'm not sure why II would result in a higher real interest rate and why III does not?

Many thanks

Jo
 
II Greater uncertainty about future inflation:

If lenders are unsure about how much inflation there will be in the future, they will require a higher interest rate (an "inflation risk premium") to compensate them for risk of inflation they are taking.

III a higher anticipated level of future inflation

As the inflation is expected, lenders won't require the inflation risk premium as in answer II. Nominal rates of interest will increase by the amount of the expected inflation, but real rates should be the same.

Hope this helps :)
 
I agree with Michael for II and III.

In terms of I, the reason for using an expansionary fiscal policy is probably to increase aggregate demand (and hence national income), so the economy is probably below full employment level. If this is the case, then there may be an increase in income, rather than a rise in prices.
 
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